Ed Dolan, an economics professor, wrote an article on Seeking Alpha entitled “Will Central Banks Accommodate the Oil Price Shock?”
I had responded, mistakenly, I think, to his question:
“Should central banks tighten monetary policy to counteract the effects of oil price increases and prevent general inflation? Or should they instead accommodate oil price increases with easy monetary policy, in order to maintain growth of output and employment?”
I said that I thought an increase in the price of oil would just take the money people would spend on other items and they would still have the same amount of capital so it shouldn’t cause an overall price rise in the economy. But I wasn’t taking into account that it probably would reduce overall production. At least that’s how it seems to me based on his reply:
JeffDB: No, I don’t agree. You say, “If the total amount of money in an economy remains constant, paying more for one commodity necessarily reduces the amount available for another.” That is OK so far as it goes. It is implicitly based on the equation of exchange, MV=PQ, with M=money, V=velocity, P=the price level, Q=real GDP. The simplest monetarist interpretation would consider V a constant, in which case M determines the level of nominal GDP (PQ).
In that model, the situation facing the central bank is this: If it leaves M unchanged, the increase in oil prices will reduce Q, so P will go up. If M is increased, and if Q is positively elastic with respect to P, then Q will fall less, but P will increase more.
Why does Q fall if M is constant and oil prices increase? Suppose the only goods are wheat (domestic) and oil (imported). When the world price of oil goes up relative to the world price of wheat, either the country has to accept getting by with less oil, or with less wheat (since more of the wheat has to be exported to pay for the oil). In this example, Q=quantity of wheat + quantity of oil, at constant prices, so one way or the other, Q goes down.
The attached slideshow gives a graphical interpretation. from Ed Dolan’s Econ Blog Slideshow Annex.
I’m curious as to whether his equations and graphs etc. are all compatible with Austrian theory. His idea of possibly accommodating the oil price hike by increasing the money supply to minimize unemployment and a decrease in GDP doesn’t seem to be viable in any instance. It would seem to me that would just devalue the dollar further making prices relatively cheaper for countries that don’t devalue the dollar and making it even more expensive relatively speaking once the currency adjustments work their way through the economies.
Any thoughts?
(Sorry if I don’t respond to any answers right away as I may be gone for much of the day tomorrow.)